Principal-Agent problem in Equity Markets

Structure
1. What is the Principal Agent problem ? 2. Mechanisms designed to mitigate the Principal-Agent problem 3. Crises in corporate governance
1. Accounting scandals 2. Analyst scandals 3. IPOs

4. Responses to crises in corporate governance.

1. Principal-Agent problem
One function of stock is that they allow for the separation of ownership and management.
Stockholders, the owners of a company, do not run the firm. Managers run the company, but do not own a large portion of the firm.

This separation leads to Principal-Agent problem.

1. Principal-Agent problem
Principal Agent problem arises when interests of owners (PRINCIPAL) separate from those of managers (AGENT)
Owners want to maximize profit, want managers to work as much as possible for as little as possible. Managers want to maximize their compensation (salary) and work as little as possible. Is it normal ?

2. Mechanisms to mitigate the Principal Agent problems

2.1 Stock options or Stock grants A portion of the managers compensation comes in the form of stock options or stock grants
Stock options: give the managers the right to buy a specific number of shares during a specific time at a specific price (usually discounted) Stock grants ?

2. Mechanisms to mitigate the Principal Agent problems

2.1 Stock options or Stock grants Downside: Create incentives for managers to artificially boost the stock price. Managers do not have a long term interest in increasing the value of the firm.

Largest options exercised by heads of major US companies 1997-2001

Company Lawrence Ellison Michael Eisner Oracle Walt Disney Year of exercise 2001 1998 Payout ($ million) 706 570

Michael Dell
Sanford Weil Thomas Siebel Stephen Case

Dell
Citigroup Siebel Systems AOL

2000
1997 2001 1997

233
220 175 158

2. Mechanisms
2.2 Board of directors
A group of stock holders appointed by other share holders to look after their interests. The board can dictate managements compensation and replace under-performing managers Downside: Often time the boards do a poor job,
eg: Robert Nardelli, CEO of Home Depot, in 2000-2006, despite continual declines of Home Depots share price and regular loss of market share to Lowes, his compensation increased (in 6 years he earned $240m in compensation).

2. Mechanisms
2.3 Outside pressure
Large institutional investors buy large blocks of shares and have influence over management.
Most cited is Calpers (California Public Employees Retirement System), the pension system for Calis state employees. Calpers has lots of money and is known as a very active investors. They can make call and demand changes.

Downside: you have to be large investors.

2. Mechanisms
2.4 Takeovers From within:
Known as proxy fights. A group of shareholders tries to dictate the outcome of the annual meeting by influencing other shareholders vote. Hence influence decision about the board of directors and management. Downside: expensive and rarely successful
HP merger with Compaq, Walter Hewlett, the son the companys founder dissented and engaged in a proxy fight to block the deal, even small share holders reportedly receive 20 or more phone calls.

2. Mechanisms
2.4 Takeovers From outside: hostile takeovers
A group of investor can gather sufficient funds to buy enough share to own a controlling stake in the firm. Then have the power to control management. Downside: Also very expensive.

3. Crises in Corporate governance

1. Accounting scandal
Managers cook the book to misrepresent the actual condition of their firm
WorldCom overstated profits by $11 billion. Bernie Ebbers, the CEO of WorldCom claimed that he did not understand accounting or the complex technology behind communication. 25 years in jail. Enron: hiding liabilities in complex, off-balance sheet vehicle. Jeffrey Skilling, ex-CEO sold $60 million worth of share 1 month after retiring. 3 months after that, the company declared bankruptcy.

3. Crises in Corporate governance

3.1 Accounting scandals
How were accounting firms (auditors) allowing this to happen ? Conflict of interest: Before 2003, accounting firms also engaged in management consulting, which is a lot more lucrative. Thus to assure future consulting business, the auditors perhaps let the standard slide.

3. Crises in Corporate governance

3.2 Analyst scandals
Investment banks provide overly optimistic securities recommendation. Investment banks have two sides:
Underwriting (investment banking) : bringing security to market. Trading and research side: Research and trade (usually sell) already issued securities.

Sell side research naturally is more upwardly biased.

3. Crises in Corporate governance

3.2 Analyst scandals
Merrill Lynch energy analyst was the only one on Wall St to have a buy rather than a strong buy recommendation on Enron. Andrew Fastow, Enrons CFO went over and complained, threatening to pull future investment banking business if the recommendation was not raised. In the end, adjustment was made.

3. Crises in Corporate governance

3.3 IPO
Investment banks manages IPOs. IPO stocks are hot as stock prices tend to rise after the initial launch. Several investment banks were charged with giving portions of IPOs to clients in exchange for future business.
Credit Suisse First Boston (CSFB) and Frank Quattrone. He was prosecuted in 2004 for obstructing a government probe into CSFBs behavior in allocating "hot" IPOs.

4. What has happened ?

4.1 Firms moving away from stock options to stock grants, where trading is restricted to longer time period. Align managers interests to those of owners on a more long term basis eg: Microsoft made the switch in 2003

Sarbanes Oxley Act (2001)

4.2 Sarbanes Oxley Act (2001)
Creation of Public Company Accounting Oversight Board to oversee auditing firms. CFO and CEO personally certify their firms financial reports and are subject to personal penalties if the reports are misleading. Auditors can not provide other services to clients- forced split of accounting and consulting firms.